All About the Maos: Charting China’s Cash Crunch

A cash crunch in China’s all important money markets has hit the headlines, conjuring images of the U.S. after the collapse of Lehman Brothers.

On Thursday, interbank borrowing rates hit a nosebleed-inducing 28% for seven-day loans. Bank of China – one of China’s biggest lenders – issued a denial after rumors of a default swirled. The shock has started to ripple out to the rest of the financial markets, triggering a sell-off in equities.

Is this Lehman with Chinese characteristics? The answer is no. The central bank has vast resources at its disposal to prevent a downward spiral. But it does highlight increasing stress in China’s financial sector, as growth in the real economy pushes toward a 20-year low. China Real Time charts it out.

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Money markets are an essential building block of the financial system, the place where banks lend and borrow to each other to fund their daily operations. In China, they have grown rapidly in importance. Turnover in the repo market has risen from 11 trillion yuan in 2007, equivalent to 42% of GDP, to 136 trillion yuan, equivalent to 263% of GDP, in 2012. A typical repo transaction involves one bank using a Treasury bond as security for a short-term loan from another bank.

Part of the reason for that rapid growth is a deliberate attempt by the People’s Bank of China to nurture the money markets as a way to set monetary policy. The past approach was to impose crude controls on how much banks can lend. Now China’s monetary policy makers want to use more market-determined means. By steering the rate at which banks can borrow, they can influence the cost of credit throughout the economy.

The current squeeze suggests that events may have run outside the central bank’s control. Seven-day borrowing rates touched 28% in trading Thursday, a record high. That sparked rumors in the market of everything from a default by a major bank to a secret injection of liquidity by the PBOC (later denied by the banks).

There are a number of temporary factors contributing to the current squeeze. On the demand side, tax season and a holiday in early June both added to demand for cash. Demand for extra funds from banks to meet regulatory requirements on loan-to-deposit ratios ahead of mid-year reporting is also a factor.

On the supply side, inflows of foreign exchange have slowed sharply. China’s banks purchased a net 66 billion yuan in foreign exchange in May, down from an average of 377 billion yuan in the first four months of the year. Rumors of a default in the market also added to counterparty risk, and made banks less willing to lend.

Temporary factors are important. But China’s financial system has faced tax season, holidays, and capital outflows before, without such a pronounced surge in money market rates. That suggests there is something else at work.

An overstretched financial system is part of the explanation. China’s ratio of credit to GDP ballooned to 180% in 2012, up from 123% in 2008. With growth slowing, it’s likely that an increasing share of those loans is non-performing. That forces banks to tap the money markets more aggressively for their daily operations.

The sharp increase in wealth-management products also adds to pressure on the banks. Assets in wealth-management products – investment products that offer some of the security of a deposit but higher returns – have ballooned to 7.1 trillion yuan at end 2012, from close to zero a few years ago.

The problem for the banks is that in many cases the assets in WMPs are long term, but their liabilities to investors are short term. Charlene Chu, China bank analyst at Fitch, estimates that more than 1.5 trillion yuan in WMPs will mature in the last 10 days of June. With banks tapping the money markets to repay investors, that adds to pressure on short-term borrowing rates.

The People’s Bank of China actually has multiple options for easing liquidity conditions. There are 19 trillion yuan in bank deposits sitting on reserve at the central bank. A 0.5 percentage point cut in the reserve requirement ratio would release almost 500 billion yuan of those deposits into the system, lowering rates.

The central bank could also make use of its open market operations to inject funds. So far it has done so, but too timidly to have a real impact, with a net injection of 280 billion yuan in the last three weeks.

The rumor Friday is that instead of intervening directly, the central bank has instructed big banks – which typically have a surplus of funds — to lend to small banks, which typically have a dearth. That might be why the weighted average of seven day borrowing rate has edged down to 9.3%, from 11.6% Thursday.

All of those options would ease conditions for the banks, but at the cost of letting them off the hook for their years of reckless lending. The final option, and the one which the central bank appears to prefer, is to let the banks sweat it out. That will cause some short-term pain. But it should also instill some market discipline, and encourage more rational lending in the future.

The repercussions of higher rates are already being felt across China’s financial sector.

In the corporate bond market, yields at the short end of the curve have surged as investors sell off their holdings to raise cash. The yield on AAA rated corporate bonds with a one-month maturity rose to 10% Thursday, up from 5.6% Wednesday, and considerably higher than the yield on longer maturities.

China’s equity markets have slumped, with the Shanghai Composite falling to 2084 on Thursday, down 10.3% from the end of May when the stress in money markets began.

In the real economy, even before the surge in money market rates growth has already slowed sharply. Economists have rushed to lower their forecasts, with some now expecting growth for the year below the government’s 7.5% target.

The risk going forward is that higher costs for the banks will be passed onto their customers in the form of less abundant and more costly loans. In the long term, slower expansion of credit is exactly what China’s economy needs. In the short term, the impact will be to take growth down another notch.

– Tom Orlik, with charts by Rosa de Acosta and contributions from Shen Hong

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